Hong Kong, unhitch yourself from falling US dollar

With the Fed easing and the value of the US dollar falling, Hong Kong should peg its currency to the yuan.

While all attention has been on the slow appreciation of the yuan against the U.S. dollar, little attention is given to the Hong Kong dollar, which hasn't moved at all.

This is largely understandable since Hong Kong is far smaller than mainland China, so it is even more obvious here that a change in Hong Kong's currency policy wouldn't have a significant effect on the trade balances of the U.S. and most other countries.

However, the question of the fixed exchange rate between the U.S. dollar and the Hong Kong dollar is still interesting from the perspective of the best interest of Hong Kong.

The economic case for fixed exchange rate rests mostly on the fact that decreased exchange rate volatility and uncertaintly can facilitate trade and other forms of economic interaction. However, as long as some countries have floating or adjustable exchange rates, it is only possible to have a fixed exchange rate to one currency bloc, while you must have a floating or adjustable exchange rate to the currencies that have a adjustable exchange rate relative to the currency that you have a fixed exchange rate to.

You must in other words choose which currency or currency bloc (if any) to have a fixed exchange rate and which currencies you shouldn't have a fixed exchange rate with. Since as stated above the purpose of fixed exchange rates is to facilitate trade, the most rational choice is to have a fixed exchange rate with the country that you have the largest degree of economic interaction with. That is why it is for example natural for Denmark to have its peg of the Danish krone to the euro.

In Hong Kong's case that means mainland China, which stood for 48.6% of Hong Kong's total trade in 2009. While the United States came in second, it was a very distant second with only 8.3% of Hong Kong's trade.

Now, as long as the yuan too had a fixed exchange rate with the U.S. dollar, it really didn't matter whether the peg was with the U.S. dollar or the yuan. Since the yuan was in effect part of the U.S. dollar bloc it moved up or down in the exact same way as the U.S. dollar, meaning that by having a fixed exchange rate with the U.S. dollar, the Hong Kong dollar also had a fixed exchange rate towards the yuan.

However, owing to outside pressure and to a lesser extent a will to contain inflation, China has now given up the peg and instead started to have a managed and adjustable exchange rate for the yuan that gradually appreciates against the U.S. dollar. This means that the yuan will also gradually appreciate against the Hong Kong dollar, greatly weakening the exchange rate stability against its by far most important trade partner. This means that to maximize efficiency gains from its fixed exchange rate, Hong Kong should instead peg the yuan.

Furthermore, another important consideration also argues for ending the U.S. dollar peg. That consideration is how sound or unsound monetary policies are in the country you have a fixed exchange rate with. If you have a fixed exchange rate and free capital flows you will no longer have an independent monetary policy, and you will instead adopt the policy of the country you have a fixed exchange rate to.

And with the Fed pushing forward with "quantitative easing", while China has started to gradually increase the value of the yuan, it should be clear that a peg to the yuan would be less inflationary than a peg to the U.S. dollar.

Hong Kong should therefore as soon as possible end its peg to the U.S. dollar, and instead peg the Hong Kong dollar to the yuan. In the long run, the Hong Kong dollar should, as Jim Rogers has argued, be abolished and replaced with a monetary union where the yuan is currency in Hong Kong. However, that should wait until the yuan is fully convertible. To make that future transition smoother, a fixed exchange rate to the yuan would be a good first step though , especially if they decide (as I think they should) upon a 1:1 exchange rate between the Hong Kong dollar and the yuan.

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